Algorithmic trading
Algorithmic trading uses computer programmes applying algorithms, which determine various aspects including price and quantity of orders, and most of the time placing them without human intervention.
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15 July 2022 Questions and Answers on MiFID II and MiFIR market structures topics, ESMA70-872942901-38 updated, provides answers to:
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The respective legal definition is comprised in Article 4(1)(39) of MiFID II. Pursuant to this provision algorithmic trading is "trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission, with limited or no human intervention, and does not include any system that is only used for the purpose of routing orders to one or more trading venues or for the processing of orders involving no determination of any trading parameters or for the confirmation of orders or the post-trade processing of executed transactions."
Moreover, Article 18 of the Commission Delegated Regulation (EU) 2017/565 of 25 April 2016 explains the notion of a system with “no or limited human intervention” - it is where, for any order or quote generation process or any process to optimise order-execution, an automated system makes decisions at any of the stages of initiating, generating, routing or executing orders or quotes according to pre-determined parameters.
Algorithmic trading includes arrangements where the system makes decisions, other than only determining the trading venue or venues on which the order should be submitted, at any stage of the trading processes including at the stage of initiating, generating, routing or executing orders (Recital 21 of the said Commission Delegated Regulation 2017/565).
Algorithmic trading means trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as:
- whether to initiate the order;
- the timing, price or quantity of the order; or
- how to manage the order after its submission;
with limited or no human intervention.
Algorithmic trading does not include any system that is only used for:
- routing orders to one or more trading venues;
- processing of orders involving no determination of any trading parameters;
- confirmation of orders; or
- the post-trade processing of executed transactions.
Financial Conduct Authority, Markets in Financial Instruments Directive II Implementation – Consultation Paper I (CP15/43), December 2015, CP15/43, p. 206-207
Hence, algorithmic trading encompasses not only the automatic generation of orders but also the optimisation of order-execution processes by automated means. Interestingly, even the use of a relatively simple algorithm qualifies as algorithmic trading in the light of MiFID rules.
According to the ESMA clarification of 19 December 2016 (Questions and Answers on MiFID II and MiFIR market structures topics, ESMA/2016/1583) "the fact that a person or firm undertakes trading activity by means of an algorithm which includes a small number of processes (e.g. makes quotes that replicate the prices made by a trading venue) does not disqualify the firm running such algorithm from being engaged in algorithmic trading."
Conversely, if an investment firm merely transmits a client's order for execution to another investment firm who uses algorithmic trading, the transmitting investment firm is not engaged in algorithmic trading (ESMA has confirmed such an interpretation explicitly in the said Q&As of 19 December 2016: "the transmission of an order for execution to another investment firm without performing any algorithmic trading activity is not algorithmic trading").
A subset of algorithmic trading is High Frequency Trading (HFT).
The term "automated trading" is also sometimes differentiated, it means the use of computer programmes to enter trading orders where the computer algorithm decides on aspects of execution of the order such as the timing, quantity and price of the order.
Legal requirements for algo firms
Investment firms engaging in algorithmic trading and trading venues where such trading takes place are subject to enhanced regulatory scrutiny. In particular, algo firms must abide by the Commission Delegated Regulation (EU) 2017/589 of 19 July 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards specifying the organisational requirements of investment firms engaged in algorithmic trading (also known as RTS 6).
Regulated markets must have effective systems, procedures and arrangements, including requiring members or participants to carry out appropriate testing of algorithms and providing environments to facilitate such testing, to ensure that algorithmic trading systems cannot create or contribute to disorderly trading conditions on the market and to manage any disorderly trading conditions which arise from such algorithmic trading systems, including systems to limit the ratio of unexecuted orders to transactions that may be entered into the system by a member or participant, to be able to slow down the flow of orders if there is a risk of its system capacity being reached and to limit and enforce the minimum tick size that may be executed on the market (Article 48(6) of MiFID II).
Pursuant to Article 17(1) MiFID II, an investment firm that engages in algorithmic trading must, moreover, have in place:
- effective systems and risk controls suitable to the business it operates to ensure that its trading systems are resilient and have sufficient capacity, are subject to appropriate trading thresholds and limits and prevent the sending of erroneous orders or the systems otherwise functioning in a way that may create orcontribute to a disorderly market;
- effective systems and risk controls to ensure the trading systems cannot be used for any purpose that is contrary to the MAR Regulation or to the rules of a trading venue to which it is connected;
- effective business continuity arrangements to deal with any failure of its trading systems and shall ensure its systems are fully tested and properly monitored to ensure that they meet the requirements laid down above.
Other MiFID II requirements for algo firms cover, in particular:
– there must be a clear and formalised governance framework,
– compliance staff must have at least a general understanding of algorithmic trading and contact with individuals who have access to functionality to cancel all unexecuted orders,
– where there is IT outsourcing, the firm remains fully responsible for its regulatory obligations,
– the firm must have sufficient appropriately trained technical, legal, monitoring, risk and compliance staff,
– the firm must employ an automated surveillance system to detect market manipulation,
– the firm must have pre-trade controls in respect of price, value, trade volumes, message volumes, trader permissions, and, market and credit risk limits,
– there must be real time monitoring of all activity under its trading code for signs of disorderly trading, and, effective post-trade controls,
- systems must be fully tested (including conformance testing with the venue) before deployment and deployed or substantially updated only on the authority of a senior management designate and only where there are predefined trading limits,
- the firm must maintain defined pre-trade controls on order entry, monitor all trading activity under its trading code on a real-time basis, and continuously operate post- trade controls, including of its market and credit risk,
- the firm must have emergency ‘kill functionality’, allowing it to cancel all unexecuted orders with immediate effect (compliance staff must maintain contact with the individual at the firm who is able to cancel immediately any or all of the firm’s unexecuted orders).
The firm engaging in the algorithmic trading must carry out an annual self-assessment and issue a validation report covering:
– its algorithmic systems and strategies,
– the governance and control framework,
– its business continuity arrangements,
– stress testing,
– its overall compliance with the other MiFID II requirements.
Specific requirements apply if an investment firm:
- engages in algorithmic trading to pursue a market making strategy (Article 17(3) and (4) of MiFID II),
- provides direct electronic access to a trading venue (Article 17(5) of MiFID II).
In the update of 15 July 2022 of the document Questions and Answers on MiFID II and MiFIR market structures topics (ESMA70-872942901-38 Question 34) ESMA provided its opinion how firms should ensure compliance with the requirements in Article 17 of MiFID II and RTS 6 when using third party systems which offer algorithmic trading functionalities.
According to the ESMA When firms use third party systems offering algorithmic trading functionalities, they are ultimately responsible for compliance with the relevant requirements in Article 17 of MiFID II and RTS 6, as specifically detailed in Article 4 or RTS 6. However, lacking direct control over the system, its operation and the algorithms deployed, these firms might not be materially able to ensure that all requirements are met.
In such instances, firms can ensure compliance with those technical requirements that cannot be otherwise met by the firm itself through contractual arrangements with the system provider, where the latter commits to ensure that the system, its operation and the algorithms deployed are compliant with the relevant legal requirements.
Pre-trade controls
The MiFID II requirements for pre trade risk controls are set out in detail within Article 15 of RTS 6, which requires algo firms to maintain:
- market and credit risk limits,
- maximum order volumes and maximum order values,
- maximum message limits,
- repeated automated execution throttles (to pause application of the strategy until restarted by human intervention),
- price collars.
However, as observed by the UK FCA in the document of February 2018 “Consultation Paper, Algorithmic trading” (CP5/18)), the level of sophistication within the pre-trade controls used by investment firms exhibits significant differences. The said FCA’s document contains in this regard the following overview (p. 17):
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Pre-trade control
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Basic controls | Enhanced controls |
| Market and credit limits | Overall credit/market risk limits set across all trading activity, applicable throughout the trading day | Market/credit risk limits split across the firms trading activity within a set time period (e.g. 15 min window) or exposures per symbol |
| Order volume/value | Volume and value limits for orders set per client/trading strategy which applied to all trading activity |
Volume and value limits, set dynamically in relation to the average daily volume (ADV) and touch size for the relevant symbol |
| Message limits | A basic limit on the number of orders or messages across all trading activity during the trading day | Message limits broken down into smaller time periods (e.g. 15 min) and/or per symbol |
| Repeated automation throttles | A check on repeated orders across all activity during the trading day | A check on repeated orders and the number of rejected orders across all activity during the trading day |
| Price collars | Price controls which apply a basic check on limit orders vs the current market price | Price collars which differentiated between passive/aggressive orders and/or calculate the anticipated market impact of the order |
Post-trade controls
Algo firms must maintain post-trade risk controls to monitor their trading activity and take appropriate action where controls are triggered. Article 17 of RTS 6 requires firms to:
- conduct a continuous assessment and monitoring of market and credit risk exposures (these must be capable of being calculated real-time),
- adopt controls over maximum longs and shorts (and overall strategy positions) for derivatives, specific to the instrument,
- maintain complete, accurate and consistent trade and account information,
- maintain electronic trading logs, reconciled with relevant third parties such as trading venues, brokers, DEA providers,
- ensure traders and the risk function undertakes post-trade monitoring.
Procedures for identification of algorithmic trading
As was said above, even the trading with the use of an algorithm including a small number of relatively simple processes can trigger legal requirements involved with MiFID II algorithmic trading regime. Firms, therefore, need to develop processes to identify algorithmic trading across the business, they must also to establish processes to capture all new algorithms, trading systems and strategies on an ongoing basis, as well as any material or substantial changes to existing ones (which was underlined by the UK FCA in the document of February 2018 “Consultation Paper, Algorithmic trading” (CP5/18)). It is important for firms to have the correct tools in place, supported by appropriate staff training, to identify all such activity. As the FCA in the above document acknowledges, the exact definition and scope of algorithmic trading can vary depending on the type of firm and strategies deployed. Nevertheless, in general terms, the algorithmic trading strategies can be defined as:
1. investment decision algorithms (determining which financial instruments should be purchased or sold), or
2. execution algorithms (optimising order execution processes with the automated submission of orders and quotes to one or more trading venues),
3. single algorithmic trading strategy combining both of the above elements.
According to the FCA’s aforementioned document of February 2018, investment decision algorithms that do not initiate orders or the timing, price or quantity of an order may not fall under the definition in MIFID II but there is a good practice to ensure these were subject to the same systems and controls as for algorithmic trading.
It is useful to note in this context the difference between Smart Order Routers (SORs) and Automated Order Routers (AOR)
Smart Order Routers (SORs) use algorithms for optimisation of order execution processes that determine parameters of the order other than the venue or venues where the order should be submitted. SORs are undoubtedly qualified as algorithmic trading.
In turn, algorithmic trading does not encompass Automated Order Routers (AOR) where, although using algorithms, such devices only determine the trading venue or venues.
The inherent condition for AOR is that the order is submitted without changing any other parameter of the order (including modifying the size of the order by "slicing" it into "child" orders).
In case the same unmodified order is sent to several trading venues to ensure execution and it is executed in one of these venues, the functionality can also cancel the unexecuted orders in the other venues without qualifying as algorithmic trading.
In the update of 15 July 2022 of the document Questions and Answers on MiFID II and MiFIR market structures topics (ESMA70-872942901-38, Question 33) ESMA explained that orders that are executed through functionalities which additionally to routing orders to trading venues offer automated managing of the order (e.g. automatically redirecting unexecuted portions of such orders to other venues or slicing orders prior to execution) are in the scope of the MiFID II definition of algorithmic trading.
Such functionalities differ from automated order routing systems, as the latter merely determine the trading venue (or trading venues) to which the order has to be sent without changing any parameter of the order (i.e. the order is unmodified in its components, including its size).
On the contrary, algorithmic trading encompasses both the automatic generation of orders and the optimisation of order-execution processes (e.g. slicing of orders) by automated means. Orders executed through such processes should therefore be flagged as algorithmic trading in line with the requirements under Articles 25(2) and 26(3) of MiFIR and Article 8 of RTS 22 and the further specification in Articles 2(c) of CDR 2017/580.
Firms trading through these functionalities should also be considered as engaged in algorithmic trading and apply, the relevant requirements of Article 17 of MiFID II and RTS 6.
Algo flagging
Regulated markets must identify, by means of flagging from members or participants, orders generated by algorithmic trading, the different algorithms used for the creation of orders and the relevant persons initiating those orders. That information is available to competent authorities upon request (Article 48(8) of MiFID II).
Registration requirement
An investment firm that engages in algorithmic trading in a EU Member State must notify this to the competent authorities of its home Member State and of the trading venue at which the investment firm engages in algorithmic trading as a member or participant of the trading venue.
The competent authority of the home Member State of the investment firm may require the investment firm to provide, on a regular or ad-hoc basis, a description of the nature of its algorithmic trading strategies, details of the trading parameters or limits to which the system is subject, the key compliance and risk controls that it has in place to ensure the conditions laid down above are satisfied and details of the testing of its systems.
The competent authority of the home Member State of the investment firm may, at any time, request further information from an investment firm about its algorithmic trading and the systems used for that trading.
The aforementioned information is communicated by the competent authority of the home EU Member State of the investment firm on the request of a competent authority of a trading venue at which the investment firm as a member or participant of the trading venue is engaged in algorithmic trading.
The investment firm must keep appropriate records and ensure that those records are sufficient to enable its competent authority to monitor compliance with the respective requirements.
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Spanish CNMV Notification form of activities related with algorithmic trading
French AMF Notification of algorithmic trading and direct electronic access provision
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MiFID II Article 17
Algorithmic trading
1. An investment firm that engages in algorithmic trading shall have in place effective systems and risk controls suitable to the business it operates to ensure that its trading systems are resilient and have sufficient capacity, are subject to appropriate trading thresholds and limits and prevent the sending of erroneous orders or the systems otherwise functioning in a way that may create orcontribute to a disorderly market. Such a firm shall also have in place effective systems and risk controls to ensure the trading systems cannot be used for any purpose that is contrary to Regulation (EU) No 596/2014 or to the rules of a trading venue to which it is connected. The investment firm shall have in place effective business continuity arrangements to deal with any failure of its trading systems and shall ensure its systems are fully tested and properly monitored to ensure that they meet the requirements laid down in this paragraph.
2. An investment firm that engages in algorithmic trading in a Member State shall notify this to the competent authorities of its home Member State and of the trading venue at which the investment firm engages in algorithmic trading as a member or participant of the trading venue.
The competent authority of the home Member State of the investment firm may require the investment firm to provide, on a regular or ad-hoc basis, a description of the nature of its algorithmic trading strategies, details of the trading parameters or limits to which the system is subject, the key compliance and risk controls that it has in place to ensure the conditions laid down in paragraph 1 are satisfied and details of the testing of its systems.
The competent authority of the home Member State of the investment firm may, at any time, request further information from an investment firm about its algorithmic trading and the systems used for that trading.
The competent authority of the home Member State of the investment firm shall, on the request of a competent authority of a trading venue at which the investment firm as a member or participant of the trading venue is engaged in algorithmic trading and without undue delay, communicate the information referred to in the second subparagraph that it receives from the investment firm that engages in algorithmic trading.
The investment firm shall arrange for records to be kept in relation to the matters referred to in this paragraph and shall ensure that those records be sufficient to enable its competent authority to monitor compliance with the requirements of this Directive.
An investment firm that engages in a high-frequency algorithmic trading technique shall store in an approved form accurate and timesequenced records of all its placed orders, including cancellations of orders, executed orders and quotations on trading venues and shall make them available to the competent authority upon request.
3. An investment firm that engages in algorithmic trading to pursue a market making strategy shall, taking into account the liquidity, scale and nature of the specific market and the characteristics of the instrument traded:
(a) carry out this market making continuously during a specified proportion of the trading venue’s trading hours, except under exceptional circumstances, with the result of providing liquidity on a regular and predictable basis to the trading venue;
(b) enter into a binding written agreement with the trading venue which shall at least specify the obligations of the investment firm in accordance with point (a); and
(c) have in place effective systems and controls to ensure that it fulfils its obligations under the agreement referred to in point (b) at all times.
4. For the purposes of this Article and of Article 48 of this Directive, an investment firm that engages in algorithmic trading shall be considered to be pursuing a market making strategy when, as a member or participant of one or more trading venues, its strategy, when dealing on own account, involves posting firm, simultaneous two-way quotes of comparable size and at competitive prices relating to one or more financial instruments on a single trading venue or across different trading venues, with the result of providing liquidity on a regular and frequent basis to the overall market.
5. An investment firm that provides direct electronic access to a trading venue shall have in place effective systems and controls which ensure a proper assessment and review of the suitability of clients using the service, that clients using the service are prevented from exceeding appropriate pre-set trading and credit thresholds, that trading by clients using the service is properly monitored and that appropriate risk controls prevent trading that may create risks to the investment firm itself or that could create or contribute to a disorderly market or could be contrary to Regulation (EU) No 596/2014 or the rules of the trading venue. Direct electronic access without such controls is prohibited.
An investment firm that provides direct electronic access shall be responsible for ensuring that clients using that service comply withthe requirements of this Directive and the rules of the trading venue. The investment firm shall monitor the transactions in order to identify infringements of those rules, disorderly trading conditions or conduct that may involve market abuse and that is to be reported to the competent authority. The investment firm shall ensure that there is a binding written agreement between the investment firm and the client regarding the essential rights and obligations arising from the provision of the service and that under the agreement the investment firm retains responsibility under this Directive.
An investment firm that provides direct electronic access to a trading venue shall notify the competent authorities of its home Member State and of the trading venue at which the investment firm provides direct electronic access accordingly.
The competent authority of the home Member State of the investment firm may require the investment firm to provide, on a regular or ad-hoc basis, a description of the systems and controls referred to in first subparagraph and evidence that those have been applied.
The competent authority of the home Member State of the investment firm shall, on the request of a competent authority of a trading venue in relation to which the investment firm provides direct electronic access, communicate without undue delay the information referred to in the fourth subparagraph that it receives from the investment firm.
The investment firm shall arrange for records to be kept in relation to the matters referred to in this paragraph and shall ensure that those records be sufficient to enable its competent authority to monitor compliance with the requirements of this Directive.
6. An investment firm that acts as a general clearing member for other persons shall have in place effective systems and controls to ensure clearing services are only applied to persons who are suitable and meet clear criteria and that appropriate requirements are imposed on those persons to reduce risks to the investment firm and to the market. The investment firm shall ensure that there is a binding written agreement between the investment firm and the person regarding the essential rights and obligations arising from the provision of that service.
7. ESMA shall develop draft regulatory technical standards to specify the following:
(a) the details of organisational requirements laid down in paragraphs 1 to 6 to be imposed on investment firms providing different investment services and/or activities and ancillary services or combinations thereof, whereby the specifications in relation to the organisational requirements laid down in paragraph 5 shall set out specific requirements for direct market access and for sponsored access in such a way as to ensure that the controls applied to sponsored access are at least equivalent to those applied to direct market access;
(b) the circumstances in which an investment firm would be obliged to enter into the market making agreement referred to in point (b) of paragraph 3 and the content of such agreements, including the proportion of the trading venue’s trading hours laid down in paragraph 3;
(c) the situations constituting exceptional circumstances referred to in paragraph 3, including circumstances of extreme volatility, political and macroeconomic issues, system and operational matters, and circumstances which contradict the investment firm’s ability to maintain prudent risk management practices as laid down in paragraph 1;
(d) the content and format of the approved form referred to in the fifth subparagraph of paragraph 2 and the length of time for which such records must be kept by the investment firm.
ESMA shall submit those draft regulatory technical standards to the Commission by 3 July 2015.
Power is delegated to the Commission to adopt the regulatory technical standards referred to in the first subparagraph in accordance with Articles 10 to 14 of Regulation (EU) No 1095/2010.
MIFID II Article 48(6) and (10)
6. Member States shall require a regulated market to have in place effective systems, procedures and arrangements, includingrequiring members or participants to carry out appropriate testing of algorithms and providing environments to facilitate such testing,to ensure that algorithmic trading systems cannot create or contribute to disorderly trading conditions on the market and to manageany disorderly trading conditions which do arise from such algorithmic trading systems, including systems to limit the ratio ofunexecuted orders to transactions that may be entered into the system by a member or participant, to be able to slow down the flowof orders if there is a risk of its system capacity being reached and to limit and enforce the minimum tick size that may be executedon the market.
10. Member States shall require a regulated market to be able to identify, by means of flagging from members or participants, orders generated by algorithmic trading, the different algorithms used for the creation of orders and the relevant persons initiating thoseorders. That information shall be available to competent authorities upon request.
Commission Delegated Regulation (EU) 2017/565 of 25 April 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive
Article 18
Algorithmic trading
(Article 4(1)(39) of Directive 2014/65/EU)
For the purposes of further specifying the definition of algorithmic trading in accordance with Article 4(1)(39) of Directive 2014/65/EU, a system shall be considered as having no or limited human intervention where, for any order or quote generation process or any process to optimise order-execution, an automated system makes decisions at any of the stages of initiating, generating, routing or executing orders or quotes according to pre-determined parameters.
Recitals 21 and 22
(21) Algorithmic trading in accordance with Article 4(1)(39) of Directive 2014/65/EU should include arrangements where the system makes decisions, other than only determining the trading venue or venues on which the order should be submitted, at any stage of the trading processes including at the stage of initiating, generating, routing or executing orders. Therefore, it should be clarified that algorithmic trading, which encompasses trading with no or limited human intervention, should refer not only to the automatic generation of orders but also to the optimisation of order- execution processes by automated means.
(22) Algorithmic trading should encompass smart order routers (SORs) where such devices use algorithms for optimisation of order execution processes that determine parameters of the order other than the venue or venues where the order should be submitted. Algorithmic trading should not encompass automated order routers (AOR) where, although using algorithms, such devices only determine the trading venue or venues where the order should be submitted without changing any other parameter of the order.
Commission Delegated Regulation (EU) 2017/584 of 14 July 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards specifying organisational requirements of trading venues (RTS 7), Article 1
Article 1
Subject matter and scope
(Article 48 of Directive 2014/65/EU)
1. This Regulation lays down detailed rules for the organisational requirements of the systems of the trading venues allowing or enabling algorithmic trading, in relation to their resilience and capacity, requirements on trading venues to ensure appropriate testing of algorithms and requirements in relation to the controls concerning DEA pursuant to Article 48(12)(a),(b) and (g) of Directive 2014/65/EU.
2. For the purposes of this Regulation, it is considered that a trading venue allows or enables algorithmic trading where order submission and order matching is facilitated by electronic means.
3. For the purposes of this Regulation, any arrangements or systems that allow or enable algorithmic trading shall be considered ‘algorithmic trading systems’.
Questions and Answers on MiFID II and MiFIR market structures topics, 19 December 2016, ESMA/2016/1583
Question 1 [Last update: 19/12/2016]
Does a simple algorithm qualify as algorithmic trading?
Answer 1
Yes. The fact that a person or firm undertakes trading activity by means of an algorithm which includes a small number of processes (e.g. makes quotes that replicate the prices made by a trading venue) does not disqualify the firm running such algorithm from being engaged in algorithmic trading.
Question 2 [Last update: 19/12/2016]
If an investment firm (firm A) merely transmits a client's order for execution to another investment firm (firm B) who uses algorithmic trading, is investment firm A engaged in algorithmic trading?
Answer 2
No. The transmission of an order for execution to another investment firm without performing any algorithmic trading activity is not algorithmic trading.
Question 3 [Last update: 19/12/2016]
Can a functionality be considered as an Automated Order Router (AOR) if it submits the same order to several trading venues? Would that qualify as algorithmic trading?
Answer 3
According to Recital 22 of Commission Delegated Regulation of 25.4.2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive, an AOR is characterized by only determining the trading venue or trading venues to which the order has to be sent without changing any other parameter of the order (including modifying the size of the order by "slicing" it into "child" orders). In case the same unmodified order is sent to several trading venues to ensure execution and it is executed in one of these venues, the functionality can also cancel the unexecuted orders in the other venues without qualifying as algorithmic trading.
Questions and Answers on MiFID II and MiFIR market structures topics, ESMA70-872942901-38
Direct electronic access (DEA) and algorithmic trading
Question 4 [Last update: 31/01/2017]
Do the references to ‘market makers’ in MiFID II Article 2(1)(d)(i) and Article 2(1)(j) cover those market makers as defined under MiFID II Article 4(1)(7) or those firms engaged in a market making agreement according to Article 17(4) of MiFID II?
Answer 4
The reference to market makers’ in MiFID II Article 2(1)(d)(i) and Article 2(1)(j) covers both firms engaged in a market making agreement according to Article 17(4) of MiFID II and other market makers covered by Article 4(1)(7) of MiFID II.
Question 5 [Last update: 03/04/2017]
How should the identification and authorisation take place for those firms applying a High-Frequency Trading (HFT) technique?
Answer 5
The mechanics of identifying whether a firm is deemed to be applying a HFT technique are detailed in Article 19 of Commission Delegated Regulation (EU) 2017/565. Firms should review their trading activities at least on a monthly basis to self-assess whether an authorisation requirement has been triggered over the course of the period in question. Upon request, trading venues must provide their members, participants or clients with an estimate of the average number of messages per second two weeks after the end of each calendar month. For this purpose, trading venues should only include messages generated by algorithmic trading activity as identified by the member, participant or client.
However, the onus remains on firms to ensure that the estimates provided by the trading venues accurately reflect their actual trading activity (and in particular that it only takes into account proprietary algorithmic trading activity on liquid instruments excluding, in the case of DEA providers, messages sent by DEA clients using the firm’s code).
Where a firm engages in HFT (as described above) and is not authorised as an investment firm under MiFID II, the firm is required to immediately seek authorisation as required under Article 2(1)(d)(iii) of MiFID II.
ESMA reminds that any firm engaged in algorithmic trading (including HFT) has to notify this circumstance to the national competent authority of its home Member State and to the national competent authorities of the trading venues at which it engages in algorithmic trading as member or participant.
Question 6 [Last update: 03/04/2017]
Given that the identification of HFT technique takes into account the previous twelve months of trading and that trading venues are only obliged to provide the data under Article 19 of Commission Delegated Regulation (EU) 2017/565 as of 3 January 2018, when the actual identification as high-frequency traders is expected to take place?
Answer 6
Trading venues are only required by Article 19(5) of Commission Delegated Regulation (EU) 2017/565 to provide estimates of the average of messages per second as of 3 January 2018. As a consequence, over 2018 trading venues have to provide the estimates corresponding to the trading activity of their members/participants from 3 January 2018 onwards. Trading venues may only be able to provide those estimates taking into account the previous twelve months of trading activity in the second week of February 2019. Provided that their 2017 records allow them so, trading venues may provide estimates taking into account the previous twelve months before that date.
As of 3 January 2018, persons engaged in algorithmic trading are responsible for their own self-assessment to determine whether their trading activity meets the characteristics of HFT as set out under Article 4(1)(40) of MiFID II and Article 19 of Commission Delegated Regulation (EU) 2017/565. If it is the case, they should proceed immediately as described in Answer 5. ESMA notes in this respect that the information provided by trading venues are only estimates that need to be refined according to each person’s own records of the messages sent.
Question 7 [Last update: 03/04/2017]
Can DEA users be identified as applying a HFT technique?
Answer 7
Yes. As clarified under Recital 20 of Commission Delegated Regulation (EU) 2017/565, DEA users may be classified as HFTs if they meet the conditions set out under Article 4(1)(40) of MiFID II and Article 19 Commission Delegated Regulation (EU) 2017/565.
In order to assess whether a DEA user meets the applicable message thresholds, firms accessing trading venues through DEA may contact their DEA provider which is obliged to record the data relating to the orders submitted, including modifications and cancellations under Article 21(5) of RTS 6 (Commission Delegated Regulation (EU) 2017/589 of 19 July 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards specifying the organisational requirements of investment firms engaged in algorithmic trading (OJ L 87, 31.3.2017, p. 417–448)).
However, the onus remains on investment firms to ensure that the estimates provided by the DEA providers accurately reflect their actual trading activity (and in particular that it only takes into account proprietary trading activity on liquid instruments excluding, in the case of DEA users sub-delegating the DEA provider’s code, messages sent by their own DEA clients).
Question 8 [Last update: 03/04/2017]
When would an investment firm using only algorithms which draw human traders’ attention to trading opportunities qualify as engaged in algorithmic trading?
Answer 8
The use of algorithms which only serve to inform a trader of a particular investment opportunity is not considered as algorithmic trading, provided that the execution is not algorithmic.
Question 9 [Last update: 03/04/2017]
Does the MiFID II obligation relating to algorithmic trading apply to electronic OTC trading? Are algorithms that provide quotes/orders to customers subject to the requirements set out in MiFID II?
Answer 9
Article 17 of MiFID II covers the trading activity that takes place on a trading venue. Therefore, OTC trading activity, such as the generation of quotes sent bilaterally to clients is not covered by the provisions in Article 17 of MiFID II (and any further requirements thereof).
Question 10 [Last update: 03/04/2017]
Please explain what is meant by Article 17(3) of RTS 6 which requires investment firms to “reconcile” their own electronic logs with information about their outstanding orders and risk exposures as provided by the trading venues to which they send orders, their brokers or DEA providers, their clearing members or CCP, their data providers or other relevant business partners?
Answer 10
The goal of post-trade controls is mainly to enable firms engaged in algorithmic trading to undertake appropriate management of their market and credit risk. To that end, and in order to make sure that post-trade controls are based on reliable information, Article 17(3) of RTS 6 requires investment firms to reconcile their own electronic logs with information about their outstanding orders and risk exposures as provided by external parties. This should be understood as an obligation to compare the trading activity’s reports generated by the investment firm itself with reports from other external sources. This should contribute in particular to:
a) Early detection of any discrepancy between the different data sources and mitigation of errors and malfunctions;
b) Accurate calculation of the firm’s actual exposure (in particular, where it accesses different multiple trading systems and/or brokers) and the timely generation of adequate alerts before the position and loss limits set out by the firm have been breached.
Question 11 [Last update: 03/04/2017]
Are firms required to store market data in order to fulfil the requirements contained in Article 13(7) of RTS 6 regarding the replay functionality of surveillance systems?
Answer 11
Under Article 13(1) of RTS 6, investment firms engaged in algorithmic trading are obliged to have in place monitoring systems capable of generating operable alerts to indicate potential market abuse. To that end, firms have to take into account not only their own message, order flow and transaction records but also information from other sources (trading venues, brokers, clearing members, CCPs, data providers, relevant business partners and so forth) which constitute not only the input used to generate messages but also the context of the trading activity.
Under Article 13 of RTS 6 there is no obligation to store internally all the information from other sources as long as it is possible to retrieve that information to operate the replay function.
Those operable alerts may lead to the submission to the national competent authority of a Suspicious Transaction or Order Report (STOR) under the Market Abuse Regulation (MAR). In particular, Article 5(3) of Commission Delegated Regulation (EU) 2016/957 of 9 March 2016 supplementing Regulation (EU) No 596/2014 of the European Parliament and of the Council with regard to regulatory technical standards for the appropriate arrangements, systems and procedures as well as notification templates to be used for preventing, detecting and reporting abusive practices or suspicious orders or transactions (OJ L 160, 17.6.2016, p. 1–14) prescribes that the information submitted as part of a STOR has to be based on facts and analysis, taking into account all information available to them.
Additionally, there is an obligation to maintain for a period of five years the information documenting the analysis carried out with regard to orders and transactions that could constitute market abuse which have been examined and the reasons for submitting or not submitting a STOR. That information shall be provided to the competent authority upon request (Article 3(8) of Commission Delegated Regulation (EU) 2016/957).
Question 12 [Last update: 03/04/2017]
Article 20 of Commission Delegated Regulation (EU) 2017/565 further clarifies the definition of direct electronic access as per Article 4(1)(41) of MiFID II by stating that persons shall be considered not capable of electronically transmitting orders relating to a financial instrument directly to a trading venue in accordance with Article 4(1)(41) of MiFID II where that person cannot exercise discretion regarding the exact fraction of a second of order entry and the lifetime of the order within that timeframe. What does “exercise discretion regarding the exact fraction of a second” mean?
Answer 12
One of the benefits of accessing a trading venue by DEA is in the ability of the firm submitting the order to exercise greater control over the timing of order submission. The use of DEA without passing through appropriate control filters of the provider of DEA and those of the trading venue, is not permitted under MiFID II. Such filters add minimal, but a finite amount of delay to the order reaching the matching engine of the trading venue and as such some may preclude the possibility of a firm submitting such an order to exercise discretion regarding the exact fraction of a second.
However, the phrase in question should be construed as whether the DEA user in question is able to exercise discretion regarding the exact fraction of a second in sending an order, not the exact timing of an order reaching the matching engine. This is a natural interpretation given that current network routing technology cannot provide certainty for a message to reach its destination with the precision of “exact fraction of a second”.
Question 13 [Last update: 31/05/2017]
What is meant by “continuous” assessment and monitoring of market and credit risk in Article 17(2) of RTS 6 which relates to investment firms’ post trade controls?
Answer 13
Under Article 13(1) of RTS 6, investment firms engaged in algorithmic trading are obliged to have in place monitoring systems capable of generating operable alerts to indicate potential market abuse. To that end, firms have to take into account not only their own message, order flow and transaction records but also information from other sources (trading venues, brokers, clearing members, CCPs, data providers, relevant business partners and so forth) which constitute not only the input used to generate messages but also the context of the trading activity.
Question 28 [Last update: 04/10/2018]
Do the provisions of Article 17(6) of MiFID II and of Chapter IV of RTS 6 apply to all general clearing members or only to those clearing members having algorithmic traders as clients?
Answer 28
Article 17(6) of MiFID II targets investment firms acting as general clearing members, without mentioning algorithmic trading nor restricting the scope to those clearing members having algorithmic traders as clients. Therefore, Article 17(6) should be interpreted as applying to all firms acting as general clearing members, regardless of the nature of their clients. Analogously, the provisions in Chapter IV of RTS 6 are drafted without any reference to algorithmic trading and should apply to all general clearing members. This reading is reinforced by Recital 1 of RTS 6, which defines the scope of RTS 6 differentiating on the one hand “Investment firms engaged in algorithmic trading” and, on the other hand, those “providing direct electronic access or acting as general clearing members”.
The title of Article 17 and RTS 6 should not be interpreted as narrowing the scope of the provisions in question, but rather suggesting that the issues addressed are more prominent with respect to algorithmic trading.
Question 9a [Last update: 05/12/2019]
Can member preferencing functionalities be used to formalise pre-arranged transactions?
Answer 9a
MiFID II requires trading venues to use transparent rules and procedures providing for fair and orderly trading and to establish objective criteria for the efficient execution of orders (Articles 19(1) and 47(1)(d) of MiFID II). ESMA considers that trading venues may implement/offer member preferencing functionalities in the trading system they operate as long as those functionalities comply with the MiFID II requirements and in particular are transparent and available to all members or participants.
However, ESMA also considers that member preferencing functionalities cannot be used to formalise pre-arranged transactions. Trading venues should monitor the use of member preferencing on any type of trading system and establish arrangements and procedures to detect attempts to use member preferencing functionalities to formalise privately negotiated trades. Should trading venues detect such use of member preferencing functionalities, they should have appropriate means in place to ensure that those trading patterns are discontinued.
ESMA reminds market participants that pre-arranged transactions may only be formalised on a trading venue when that trading venue benefits from an appropriate pre-trade transparency waiver.
Question [Last update: 05/12/2019]
To which types of trading systems does Commission Delegated Regulation (EU) 2017/584 RTS 7 apply? In particular, are trading venues without auto-matching trading systems or that explicitly prohibit algorithmic trading subject to the provisions of RTS 7?
Answer
Article 1 of RTS 7 limits the scope of application of RTS 7 to trading venues which “allow or enable algorithmic trading”. Article 1(2) of RTS 7 defines those venues as trading venues “where order submission and order matching is facilitated by electronic means”. The rationale is explained in Recital 3 which clarifies that “risks arising from algorithmic trading can be present in any type of trading system that is supported by electronic means”.
ESMA further notes that Recital 5 of RTS 7 explicitly refers to request-for-quote systems, where transactions are usually not automatically executed based on pre-set parameters and logic (i.e. no auto-matching protocols), as being within the scope of the RTS. ESMA therefore consider that the absence of an auto-matching protocol should not exclude the trading venue operating such system from the scope of RTS 7.
Similarly, an explicit prohibition of algorithmic trading does not appear sufficient for the trading venue to be excluded from the scope of the RTS considering the definition of trading venues allowing or enabling algorithmic trading provided under Article 1(2).
Nevertheless, regarding the specific application of the provisions contained in RTS 7, Recital 5 clarifies that (i) “some organisational requirements may not be appropriate for certain trading models although their trading systems could be supported to a certain extent by electronic means” and that (ii) “the specific requirements to be set in relation to request-for-quote systems or hybrid systems should be considered according to the nature, scale and complexity of the algorithmic trading activity undertaken”. ESMA would for instance consider it unreasonable to require a trading venue that explicitly prohibits algorithmic trading to offer to its clients a simulation facility for testing algorithms in conditions that are as realistic as possible (Article 10(2) of RTS 7).
Lastly, Recital 3 clarifies that voice trading systems are excluded from the scope of RTS 7. It is however important to stress that trading venues operating such systems remain subject to the organisational requirements prescribed under Article 48(1) of MiFID II.
Question 33 [Last update: 15/07/2022]
Do orders that are executed through trading functionalities which offer automated managing of the order qualify as algorithmic trading?
Answer 33
Yes. As specified in Article 4(1)(39) of MiFID II ‘algorithmic trading’ ‘means trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission, with limited or no human intervention [...]”.
Hence, orders that are executed through functionalities which additionally to routing orders to trading venues offer automated managing of the order (e.g. automatically redirecting unexecuted portions of such orders to other venues or slicing orders prior to execution) should be in the scope of the MiFID II definition of algorithmic trading. Such functionalities differ from automated order routing systems, as the latter merely determine the trading venue (or trading venues) to which the order has to be sent without changing any parameter of the order (i.e. the order is unmodified in its components, including its size).
On the contrary, algorithmic trading encompasses both the automatic generation of orders and the optimisation of order-execution processes (e.g. slicing of orders) by automated means. Orders executed through such processes should therefore be flagged as algorithmic trading in line with the requirements under Articles 25(2) and 26(3) of MiFIR and Article 8 of RTS 22 and the further specification in Articles 2(c) of CDR 2017/580. Firms trading through these functionalities should also be considered as engaged in algorithmic trading and apply, the relevant requirements of Article 17 of MiFID II and RTS 6.
Question 34 [Last update: 15/07/2022]
How should firms ensure compliance with the requirements in Article 17 of MiFID II and RTS 6 when using third party systems which offer algorithmic trading functionalities?
Answer 34
When firms use third party systems offering algorithmic trading functionalities, they are ultimately responsible for compliance with the relevant requirements in Article 17 of MiFID II and RTS 6, as specifically detailed in Article 4 or RTS 6. However, lacking direct control over the system, its operation and the algorithms deployed, these firms might not be materially able to ensure that all requirements are met.
In such instances, firms can ensure compliance with those technical requirements that cannot be otherwise met by the firm itself through contractual arrangements with the system provider, where the latter commits to ensure that the system, its operation and the algorithms deployed are compliant with the relevant legal requirements.
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